John has a bag filled with 5 red balls and 3 blue balls. What is the probability of John picking up a red ball from the bag? You might have seen the question above when you were being tested in math back in primary school. While learning about probability had seemed useless to me back then, I’m so glad that I have some knowledge in it now. You see, primary school-level math – such as simple probability – is actually very important when it comes to investing. In fact, probabilistic thinking is one of the key reasons why Warren…
John has a bag filled with 5 red balls and 3 blue balls. What is the probability of John picking up a red ball from the bag?
You might have seen the question above when you were being tested in math back in primary school. While learning about probability had seemed useless to me back then, I’m so glad that I have some knowledge in it now.
You see, primary school-level math – such as simple probability – is actually very important when it comes to investing. In fact, probabilistic thinking is one of the key reasons why Warren Buffett is a multi-billionaire now.
Investing is at its core, a game of chance. For every investment that we make, we can never be sure about how it will eventually pan out. There’s no such thing as certainty. That is why we need to have a diversified portfolio in order to defend ourselves against risks.
But how should an investment be selected? Also, what size should that investment take in our portfolio? These are important questions and is where the concept of probability comes into play.
These are the few things to consider when making probabilistic judgements:
- How much upside are you expecting from the investment?
- How certain are you of the investment eventually working out?
- What’s your expected return on the investment?
- How does that compare with your other investments in your portfolio?
Here’s how the questions can be used. Let’s say you had stumbled upon a stock – let’s call it Company B – that you think is 50% below its fair value. In other words, your upside that you expect from the stock’s 100%. But, because you know your assumptions are not the strongest, you’re only 10% certain that the investment will play out in a way that’s favourable to you. As such, the expected return on the investment is this:
10% x 100% = 10%
Now let’s say you had found another stock (let’s call it Company C). This time, it’s a stable and predictable business in which there’s a 20% upside that you’re 90% sure will materialise. The expected return is now thus:
90% x 20% = 18%
Now, should Company B (with an expected return of 10%) or C (with an expected return of 18%) take up the larger position in your portfolio? To answer the obvious, it’s C.
Using probability-based thinking to make investing decisions is important and the good thing is, it’s not that difficult to implement. Probabilistic thinking is so important to Buffett that his long-time business partner Charlie Munger once said:
“One of the advantages of a fellow like Buffett whom I’ve worked for all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations.
The next time you see your kids not doing his or her homework and arguing that the things they are learning are useless for their futures, tell them how Buffett had earned his billions with the help of a simple primary school math concept like probability.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.